Will this be the year when hedge fund investing via exchange-traded fund structures takes off? According to Deutsche Bank, whose db x-trackers subsidiary runs the largest hedge fund ETF in Europe, with €850 million accumulated since its launch in March last year, “alternative ETPs” are likely to see strong growth across the region.

“As UCITS (the European mutual fund regulation) permits these types of funds, investors disillusioned with lock-in periods, a lack of transparency and high fees are likely to continue to warm up to the hedge fund-like ETP concept”, wrote Christos Costandinides, ETF strategist at DB, in his firm’s recent 2009 Market Review and 2010 Outlook.

Or are hedge fund ETFs the latest example of tracker products straying away from their low-cost, easy-to-understand roots and into higher-margin, low-transparency areas of the financial markets?

The question is a timely one, given recent reports of London-based hedge fund manager Marshall Wace’s plans to launch an ETF based on its “MW Tops” index. Sources close to the firm predict a first quarter listing on the International Securities, London and Frankfurt stock exchanges.

Although it is a “hedge fund ETF”, the planned MW Tops Global Alpha fund has plenty of characteristics that distinguish it from competing structures.

The Tops index is based on a proprietary database of trading ideas given to Marshall Wace by over 2,000 equity sales contacts around the world. Rather than implementing trade recommendations as given, the firm applies its own algorithms to filter, compare, evaluate and rank the recommendations, noting aspects such as behavioural biases and the ability of individuals to time trades. The salespeople who provide the input to the Tops system are rewarded by being given commissions when the deals are actually executed.

The MW Tops concept is not without its critics. In a 2005 Wall Street Journal article (no longer available on the newspaper’s site, but reproduced on the Hedge Fund Regulation and Compliance blog), staff reporter Anita Raghavan wrote that some of the investment banks giving recommendations to Marshall Wace had been replicating the same trading positions internally, raising questions about conflicts of interest when dealing with other clients. However, at the time Marshall Wace stated that it "does not and cannot prevent or monitor securities firms trading on their own ideas".

In 2006, Marshall Wace launched a closed-ended fund version of its Tops strategy, incorporated in Guernsey, called MW Tops Limited. The fund, which trades in European equities, has returned less than 1% per annum since then, based on the reported net asset value, although its shares currently trade at a 5.4% discount to NAV, according to Citywire, implying a negative total return for those investors who bought at the time of the launch.

However, according to sources close to Marshall Wace, the new ETF will use a different methodology to the Guernsey-based fund, in particular by sticking to a more market-neutral stance.

Specifically, gross fund exposure levels (the total value of long and short positions, divided by the fund’s net assets) may reach 200%, which is the maximum permissible under UCITS rules, but the net exposure (the difference between the total value of long positions and the total value of shorts) will be capped at plus or minus 15% of the fund’s value. According to a copy of the investor presentation obtained by IndexUniverse.eu, turnover levels will be extremely high, at an anticipated 300% per month or 3,600% per annum.

The Tops ETF will replicate the performance of individual sub-strategies, which are organised by geographical region, subject to the overall constraints on gross and net exposure. Marshall Wace estimates that a portfolio based on equal weightings in the different regional Tops portfolios would have given a historical return of 10.6% per annum in 2002-2009, with a volatility of 5.7% and a maximum drawdown of 9.9%. In common with other hedge funds, Marshall Wace’s structure proved less market-neutral than expected in 2008, with an estimated return of -2.7% for the year (compared with a return from the HFRI equity market-neutral index of -6.2%).

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